Citigroup and J.P. Morgan Chase

Banks on trial

Did America's two largest banks go too far in their service to Enron?

UNTIL now Citigroup, and to a lesser extent J.P. Morgan Chase, have come through a slow economy in remarkably good shape—thanks in no small part to their transformation over the past decade into sophisticated and diverse investment banks. Enron has brought the dark side of this transformation to light.

Before a Senate committee this week, the two banks were slammed for structures that allegedly played a big role in Enron's efforts at accounting deceptions. In their defence, Citigroup and Morgan executives argued that the banks were, in fact, little more than Enron's victims; if further blame were needed, it should be directed at Andersen, Enron's auditor, which signed off on all transactions.

The stockmarket reacted by sending the two banks' shares down by a sixth on July 23rd, pounding other banks' shares for good measure. Whether a greater price is to be paid depends upon whether the actions are found to be merely embarrassing, rather than illegal. A case, says Diane Glossman at UBS Warburg, will not be easy to make.

The hearings focused on two sets of complex deals. The first involved so-called “pre-pay transactions”, in which banks put money up-front roughly equal to what specific energy trades might realise in future. Morgan structured 12 of these, providing $3.7 billion, while Citigroup structured 14, providing $4.8 billion. The key accounting question is whether this money should have counted as a loan, or as something closer to a payment for a future profit. If they were loans, the impact on Enron's balance sheet would have been profound. According to Robert Roach, the Senate's chief investigator, Enron's debt would have risen by 40%, while cashflow would have fallen by half. Representatives from credit agencies said that the changes would have had a harsh impact on Enron's rating and, as a result, its access to financing.

The second set was Citi's creation of a trust, called Yosemite, which issued notes to sophisticated investors, tied to Enron's creditworthiness. “Citi promised investors that the credit-linked notes would perform similarly to straight Enron bonds—and they have,” said Rick Caplan, a Citigroup executive.

“The Yosemite transactions transferred Enron risk exactly as they were intended to do,” agreed John Diaz, a managing director at Moody's. “The problem was that the actual Enron risk was different from that portrayed by Enron's incomplete and misleading financial disclosures.” Citigroup then used the money from the Yosemite offerings to fund the pre-paid transactions, creating what could appear to be a vicious circle.

All troubling for Citigroup, yet one contrarian in the market thinks things are not as bad for it as they might appear. On July 24th, the equity analysts at J.P. Morgan Chase added a big bank to its recommended list: Citigroup.